Wednesday, February 11, 2009

Don’t believe what they say

Calculated Risk points us towards a slide in the presentation that JP Morgan made when it purchased Washington Mutual. Calculated risk (falsely I think) indicates that it is relatively easy to quickly put up a stress test scenario as to end losses for various types of loan.

Anyway – back to the slide which you can find here. It presented three scenarios up to and including a “severe recession”. It is now clear that the unemployment rate will exceed the severe recession scenario in the slide. However home price appreciation (well really depreciation) from peak to trough is still considerably less than the severe recession scenario in the slide and it is still not clear we will get outcomes that bad.

When that slide was presented I thought it overly – indeed insanely bearish on housing losses – and I still do. WaMu had loan balances of 176 billion and JPM was predicting a loss over the history of those loans of 54 billion in its severe recession scenario.

To get that loss more than half the loans WaMu made had to default. If you assume any reasonable recovery the default rate probably had to be north of sixty percent.

Even in a severe recession that seemed unlikely to me. I know a few WaMu customers (middle class, northern California, financially stressed) and whilst some might default it seemed unlikely that half would.

There is – in America – a core group of people who believe that you should pay your home loan. It is bad out there – but WaMu did have some old loans in its book – which even with 40 percent house price depreciation were going to have positive equity. Also WaMu’s book was at least in part diversified by states.

If you believed in $54 billion in losses (and I don’t) then it is right that WaMu equity was worthless or near worthless even if Sheila Bair had granted some forebearance.

Why financial institutions lie

Most the time problematic banks have an incentive to spin their position as better than it is. Banks lie about the quality of the assets on their book. They do it all the time because if their capital appears adequate their cost of funds will be lower and the availability of funds will be higher. Having funds available at low cost is central to bank profitability.

Most banks have huge and responsive investor relations functions – because continuously convincing the market of their credit worthiness is a core operating function. The guys staffing these IR departments are usually nice enough – but unless you can piece together their statements over a period of years then you are probably best advised not to believe much they tell you.

Bank IR and financial management are very practiced at spin.

They will really get to lying if the Government chooses to buy bad assets from them. I can just imagine the scene – lying bankers (there is no other kind) on one side – and suckers – also known as taxpayers – on the other.

There are exceptions to the rule that financial institutions spin the positive. Ambac (a credit insurance company) is a company that is brutally bearish with you if you go do an investor relations meeting. I have done that – and you come out wanting to slash your wrists. Ambac is writing no business. It is trying to settle old claims presumably for less than the present value of the claims that they will have to pay. If they can convince people that there is a high probability they will not be around in six years to pay the claim then claimants might settle for 60 cents on the dollar now. Indeed the only reason why you wouldn’t settle for 60c on the dollar now on an Ambac claim is that you haven’t taken the hit in your own balance sheet. [Barclays is an offender here. It will not settle some claims because it does not want to recognise its own losses. Oh, and there is a high possibility that Ambac will not be around to pay the claims which will be problematic for some...]

Anyway because Ambac is trying to settle claims they have an incentive to make their credit look worse than it really is – that way you get to settle the claims cheaper. [Funnily MBIA is not playing that game. My view is that MBIA is worse than Ambac – but is pretending it is better.]

The incentives on JP Morgan

Consider the situation that JP Morgan was in when they were negotiating with Sheila Bair to convince her to confiscate WaMu and to hand it to them. JP Morgan had previously been willing to buy WaMu for $8 a share. They had done due diligence on it twice. But here was the opportunity to buy it for less-than-nothing – if you could get it confiscated first.

Bluntly JP Morgan had an incentive that few banks actually have – which is to high-ball the loss estimates. Their job was convince Sheila Bair to confiscate the bank. How do you do that? Well you tell bad stories. You have to make it seem that even in modest recessions (their severe recession case was a modest recession by current standards) that the losses would be enormous.

So – consistent with incentives – they high-balled the losses to Sheila Bair – and then – to be consistent – they highballed the losses in the public presentation. They were of course doing what bankers do – which is lying when they have the incentive to lie.

Calculated Risk swallowed that lie. They know better than to swallow overly bullish lies. They should also know better than to swallow overly bearish ones.

General rule: believe nothing bankers say when their incentive is to lie. Verify everything you can. If you can’t verify then discount veracity appropriately. If they are investment bankers they lie more convincingly than regional bankers – though both are pretty convincing.

John

PS. This was a situation where a banker (Jamie Dimon) was buying something (WaMu) from the government (Sheila Bair). The lying banker got the better end of the deal.

It won't be any different if banks sell things to government. The lying banker will get the better end of the deal. If the private sector is in for 10% of the equity it will help but not solve the problem...

PPS. I suspect I am meant to comment on the plan. I don't think there is a plan. Stress test everything is not a plan. Indeed I think the stress tests have the same lies built into them that everything else does. Third party assessments is a plan - but it requires an openness that banks are not familiar with - and perhaps a billion dollars in accounting bills (which is I guess stimulus).

7 comments:

Anonymous
said...

John: JPM's presentation slide 15 is better at showing what is behind their $176B of assets - $15B subprime, $59.5B Home Equity, $50B Option ARMs and $51B in "regular mortgages".....$33B of the option ARM Loans are in CA, FL and AZ...and you think the $54B in loss is too high?

Go inland a bit, and there are some horror stories. I know of a condo complex where the banks are typically taking 550k losses on loans of 750k (22 foreclosures in that complex). Near Palm Springs. I would imagine that things are just as bad in the Central Valley.

The carnage is happening out in the boondocks, probably far away from anywhere you have visited.

I know how bad it is out in the boondocks - and yes - there are condo complexes where two thirds will default - and the loss given default is 550 on a 750 loan. That is a 73 percent loss given default - and a two third loss rate - implying a total 50% loss.

If a half of WaMu's book was that bad (and that I doubt) and a half was 10% default and 30% loss given default you still dont quite get the 54 billion in the bad case scenario in the JPM slide.

54BB does not seem like that high a number. Ask Texas Pacific about whether its better to believe in the upside... Less than 30% of the portfolio is classified as being mortgages. Considering the majority of these loans are in Cali and Florida, I do not see the severe recession loss number as being ludicrous. Also, since the securitization markets started to push back on subprime and home eq loans back in late 2005, these loans are most likely concentrated in the great 2006/7 vintages.Of course, JP spun it somewhat to their advantage, but in about 2 years, we will be laughing at the concept of a "moderate" recession.

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